Wednesday, 27 April 2011

Talking Finance: Understanding bank lending

Firms around the world depend on several sources of capital to finance their businesses. The stock market provides long-term equity financing, the bond markets provides debt financing, and the bank market provides loans. Cambodia will soon have an equity and bond market, but historically, businesses have been financed through owner’s equity and bank borrowing.

Thus banks play an extremely vital role given the absence of alternatives. Understanding how banks evaluate loans and their decision-making process is extremely helpful for potential borrowers. Banks strongly prefer companies with an operating history and with several years of profitability. Therefore obtaining financing as a start-up company may be difficult. The bank will have lending policies based on the local market regulations and the bank’s own rules and procedures.

Lending to certain industries may be restricted for reasons such as the impact to the environment or for moral reasons. Banks will also diversify their lending portfolio by applying lending limits per industry. Local regulations must be adhered to. For example, a bank may only lend 20 percent of its capital to a single borrower, this being known as the single borrower lending limit.

Cambodia’s lending rates have improved over the last decade, yet interest rates are still perceived as higher than international market rates. How a bank prices a loan is based on several factors. The “cost of funds” is generally what a bank has to pay its depositors. This is greatly influenced by supply and demand. If the market is flush with deposits, interest rates on deposits will be lower. They will also be lower if banks restrict lending as there is less need for deposits.

If banks are actively lending and require deposits, then rates on deposits will be higher. Lending costs are also influenced by the banks’ own operating costs and the risk on the borrower. Longer tenors are priced higher as the risk on long-term loans is greater than short-term loans.

An unprepared borrower is normally its greatest enemy. There must be a clear purpose for the loan, and the uses of the requested borrowing amount must be coherently explained and verified if possible.

How the loan will be repaid and in what timeframe must be substantiated. The character of the borrower is a very important aspect of the lending decision. The history of the owners and management will weigh heavily. The competitive position of the borrower in its industry is another key determinant.

Cambodian banks, almost without exception, lend on a secured basis. Thus the value and quality of collateral pledged influences the amount the bank will lend.

Policies of banks vary. Occupied land may be given a collateral value of 50 percent of its market, building 40 percent, and vacant land less. Land and building are immovable collateral and strongly preferred.

The loan documents will include covenants. Affirmative covenants require the borrower to take certain actions, such as filing of financial statements and maintaining insurance. Negative covenants restrict the borrower from doing certain things such as taking on additional debt. These should be reviewed with scrutiny as they can lead to events of default which allow lenders to demand repayment in advance of the due date of the loan.

The complexities of obtaining a loan and satisfying the bank’s requirements are demanding. A well prepared borrower will be in a much better position.